Emerging ambiguities

Economic prospects have become more uncertain since the beginning of the year. Will the Federal Reserve be more aggressive faced with a US economy operating at full cruising speed? Does the flattening of the yield curve foreshadow a more-severe-than-expected slowdown in 2019? What will be the consequences of higher tariffs? These ambiguities have emerged at the same time as various pressures in the emerging countries: equity market indices have been in a net decline since fall 2017, yield spreads have widened considerably between USD-denominated bonds issued by emerging market companies and US Treasuries, and several emerging market currencies have dropped sharply against the dollar since early February.

There are several possible explanations. One is the specific challenges facing certain countries: Turkey and Argentina are struggling with double-digit inflation and current account deficits, which have eroded investor confidence, while Brazil must deal with an economic slowdown, social unrest and political uncertainty. The currencies of these countries have depreciated significantly via a contagion effect: wariness towards the most vulnerable emerging countries has finally spread across the board. Moreover, to the extent that the initial exposure to emerging markets had been created using index-based products (ETF, passive funds), efforts by investors to reduce their exposure to certain countries affects all of the index constituents.

The second interpretation is based on the prospects that the Federal Reserve will tighten US monetary policy. Abundant empirical research, notably by the Bank of International Settlements, shows that the Fed’s decisions affect the rest of the world via spillovers during both the easing and tightening of monetary policy. Consequently, US rate increases would trigger an appreciation of the dollar against the emerging country currencies, forcing their central banks to follow suit, independently of the economic environment in their home country. Seen in this light, solid US economic growth and recent statements by Fed officials favouring a slightly restrictive monetary policy are a source of concern for the emerging countries and their investors.

A third interpretation looks at the risks of a trade war, which could have major consequences for the emerging countries. According to the World Bank, emerging countries are more sensitive to trade wars than the advanced countries. A trade war would strain international trade and commodity prices, both of which are essential factors for many of the emerging countries. A stronger dollar fuelled by higher US tariffs would be more bad news for the emerging markets due to their high USD-denominated debt burden.

The fourth possible explanation is the dollar’s rise since February. It can strain commodity exporting countries due to the traditionally negative correlation between commodity prices and the dollar. Moreover, a stronger dollar would erode the financial health of companies from the emerging economies, whose USD-denominated debt has soared since 2008, forcing them to scale back investments. This category includes Argentina, Chile, Mexico, Indonesia, Malaysia, Russia, Turkey, Saudi Arabia, and South Africa.

Lastly, emerging market trends might be reflecting a gradual decline in international investors’ appetite for risk given the prospects of a global economic slowdown, an outlook inspired by the downturn in sentiment and confidence indicators in most countries since the beginning of the year (the US is the big exception). The flattening of the US yield curve, which in the past was a good leading indicator of recession, might also be playing a role. Under this scenario, the real concern is not the upturn in US long-term rates, but rather the higher risk premiums demanded by investors, resulting in a sharp increase in the yield spread between emerging market bonds and US Treasuries.

In conclusion, the pressures in the emerging countries that began to pick up last fall can probably be explained by a combination of factors, shocks and induced effects. As is usually the case during mature cyclical phases, two factors will play a crucial role: the level of interest rates (US rates + risk premium) and the growth profile. This first mainly concerns 2018 while the second will play a bigger role in 2019.